I’m the Washington D.C. bureau chief for Forbes and have worked in the bureau for more than two decades. I've spent much of that time reporting about taxes -- tax policy, tax planning, tax shelters and tax evasion. These days, I also edit the personal finance coverage in Forbes magazine and coordinate outside tax, retirement and personal finance contributors to Forbes.com. You can email me at jnovack@forbes.com and follow me on Twitter @janetnovack.

A federal judge has ruled former QwestQwest Communications International CEO Joseph P. Nacchio can not be barred, on public policy grounds, from claiming a tax deduction for $44.6 million in stock gains he was forced to forfeit after his conviction on insider trading charges. But before he can get the $18 million refund that deduction would produce, he must convince the judge that at the time he originally reported and paid taxes on those gains in 2001, he believed he was entitled to them—in other words, that he didn’t realize he was engaging in insider trading. Nacchio never took the stand at his own 2007 criminal trial.

In an opinion issued this week, Court of Federal Claims Judge Mary Ellen Coster Williams flatly rejected the government’s argument that allowing Nacchio to deduct the forfeited amount “would severely and immediately frustrate the strong national policy embodied in the criminal code that prohibits insider trading” by “reducing the sting” of forfeiture. Instead, she concluded, “disallowing the deduction would result in a `double sting’ by requiring the taxpayers to both make restitution and pay taxes on income they did not retain.” She noted that the Supreme Court has held the “federal income tax is a tax on net income, not a sanction against wrongdoing,” and added that “there is no reason to compound Mr. Nacchio’s criminal punishment with a tax burden Congress has neither expressly nor impliedly directed.”

Nacchio lawyer William D. Lipkind, of West Orange, N.J., said Judge Williams’ decision sets an important precedent, establishing that just because a forfeiture is ordered as a result of a criminal conviction, doesn’t mean it can’t ever be deducted. But, he added, “this is clearly not a case that says if someone robs a bank and has to give up the loot, that’s a tax deduction.” That is because a bank robber, embezzler or Ponzi schemer like Bernard Madoff, assuming he even reported his original ill gotten gains, would have a hard time arguing after conviction that he originally thought he was entitled to the income. Williams’ ruling also won’t help the vast majority of white collar criminals who enter into plea deals which require them to admit they knew they took money they weren’t entitled to.

In 2007, after a 16 day trial, a Denver federal jury convicted Nacchio of 19 counts of insider trading for selling stock option shares between April 26, 2001 and May 29. 2001. After multiple appeals, he was ultimately sentenced to 70 months in prison, hit with a $19 million fine, and ordered (as part of the sentence) to forfeit $44.6 million in stock profits, which was later incorporated into his civil settlement with the SEC and transferred to a fund for the 112,000 stock investing victims of the Qwest securities fraud. The now-64-year-old Nacchio went to prison in 2009 and was released from federal custody last September.

Criminal fines and similar penalties aren’t deductible and Nacchio didn’t try to deduct the $19 million fine he paid. But restitution can be deductible. So Nacchio and his wife, Anne M. Esker, filed an amended 2007 1040 claiming a $17.9 million refund based on the $44.6 million they had forfeited. Section 1341 of the tax code allows a taxpayer to claim a refundable credit in a current year for income reported and taxed in a prior year that he later discovers he never had a right to.

After the Internal Revenue Service denied the claim, the couple sued for a refund in 2012. The government moved for their claim to be denied on summary judgment on two grounds. First, the government argued, Nacchio wasn’t entitled to a deduction at all, on public policy grounds and because criminal penalties aren’t deductible. That’s the claim the judge flatly rejected.

Second, the government said Nacchio couldn’t use Sec. 1341 since he was convicted of “acting willfully, knowingly and with the intent to defraud,’’ and therefore couldn’t prove he believed he had a right to the forfeited gains when he originally reported and paid taxes on them in 2001. “We think that the issue that the Plaintiffs want to argue with respect to Nacchio’s state of mind has already been decided by a jury after a 16-day trial,’’ Justice Department attorney Jacob E. Christensen argued at a hearing last August.

But Williams concluded Nacchio’s state of mind back in 2001 was an issue of material fact that couldn’t be resolved on summary judgment. She wrote: “Although the jury in the criminal trial believed Mr. Nacchio was guilty of willfully engaging in insider trading, this does not equate to a finding of what Mr. Nacchio himself believed. Mr. Nacchio professed his innocence, and nothing in this Court’s record from the criminal proceeding sheds any light on the bona fides of Mr. Nacchio’s belief. Indeed, Mr. Nacchio did not testify in his criminal trial, invoking his Fifth Amendment privilege against self-incrimination. Mr. Nacchio’s subjective belief as to his claim of right to the forfeited gain was not adjudicated in his criminal trial, and Plaintiffs are not barred from litigating his belief.”

Post Your Comment

Post Your Reply

Forbes writers have the ability to call out member comments they find particularly interesting. Called-out comments are highlighted across the Forbes network. You'll be notified if your comment is called out.